Accounting firms raised questions about auction-rate securities' resemblance to cash almost three years before the market failed and before authorities cracked down on Wall Street's biggest firms for allegedly overstating the safety of the investments to investors.
In settlements with state authorities and the
Securities and Exchange Commission
agreed to buy back more than $26 billion in auction-rate securities and pay a cumulative $250 million in fines for allegedly marketing the investments to investors as an alternative to cash.
Regulators might have saved themselves the trouble years before the credit crisis set in, had they paid heed to accounting firm PricewaterhouseCoopers. In May 2005, the firm issued an opinion on auction-rate securities, arguing that the instruments should not be considered a cashlike product.
"The legal maturity of auction-rate securities is 20 to 30 years and, as such, the securities ordinarily should not be classified as cash equivalents, but rather as investments," said the note, part of Pricewaterhouse's reference materials available to clients on the firm's Web site.
The market for auction-rate securities -- debt instruments whose interest rates are reset in regular auctions -- became illiquid in February. The turmoil in the credit markets led banks to withdraw support for the auctions, which stalled, pressing state attorneys general and the SEC to action.
In addition to Citi and UBS,
on late Monday voluntarily agreed to
some $4.5 billion in auction-rate securities, and
last week voluntarily agreed to
some $26 billion.
Several other major banks, including
Bank of America
, have acknowledged subpoenas or investigations in connection with the probe.
Espen Robak, of Affiliate Pluris Valuation Advisors -- which helps banks and other financial institutions determine the value of these products -- says the banks were highly compromised.
"They were the sellers, the buyers and they were supporting the auction," he says of the firms. "They were in a unique position to know about the health of the market."
Barry Silbert, whose company Restricted Stock Partners handles a large secondary market in auction-rate securities, points out that the banks made all the proper disclosures about the inherent risk in investing in the products.
"Technically, they didn't do anything wrong," says Silbert.
Matter of Maturity
Pricewaterhouse justified its opinion based on Financial Accounting Standards Board Statement No. 95, which says that a product cannot be considered a cash management tool unless it has a maturity less than three months. Many auction-rate securities have maturities going out 20 to 30 years. It also refers to FAS 115, which allows for longer-term products to be listed as cash if purchased within three months of their maturity. So an auction-rate security should only be considered cash if purchased three months prior to maturity.
The opinion stirred up a great deal of trouble, and Wall Street quickly hired lawyers and fought back. It lobbied the FASB against Pricewaterhouse's opinion, shared by the other accounting firms who make up the Big Four, and charged them with disrupting the market. Wall Street also asked issuers to waive requirements in order to keep the rates artificially high.
The Association of Financial Professionals sent a letter in June 2005 to FASB complaining that auction-rate securities had been used as a cash tool since the 1980s and that the Pricewaterhouse opinion had introduced instability into the market.
"The change made it appear to the public that companies had done something improper, creating suspicion within the capital markets," James Kaitz, the organization's president, wrote in the letter. "Auction-rate securities represent an established, accepted and integral corporate cash management tool and should be accounted for as such."
SEC spokesman John Nester declines to comment on why the SEC remained silent on the issues raised by Pricewaterhouse in 2005. The commission continues to look at the failure of the auction-rate market, he notes.
"Among considerations for investigators is when banks knew the auctions were materially at risk for widespread failure and whether the risk was disclosed to customers," Nester says.
The SEC did censure many of the securities firms in 2006 and levied fines related to bids and prices of the products within the auction. The commission alleged some investors got better information than others on what rate to bid. Citigroup, Merrill,
and Morgan Stanley were ordered to pay $1.5 million each.
Lance Pan of Capital Advisors says the SEC did not go far enough. He points out that no real auction existed and that the SEC recognized that the auctions were "managed" and not competitive at all. But the SEC allowed the dealers to manage the auctions because the numbers were so large -- roughly $200 billion in debt was brought to market every seven to eight days.
"In order for these securities to be considered cash, they had to ensure the auctions were done in an upfront manner," says Pan, who made the same point in a 2006 note to clients.
Meanwhile, Wall Street by and large continued to offer the products to investors as a safe, better-yielding alternative to cash.
Wake Up the Watchdogs
The Financial Industry Regulatory Authority, the financial industry's self-policing organization, did not say much about auction-rate securities being labeled as cash until Regulatory Notice 8-08 issued in March 2008 -- after the auction-rate market had already failed.
"In light of the recent events in the marketplace, member firms should give careful consideration to the classification of these securities on customer statements as cash or cash equivalents," the notice read.
Nancy Condon of FINRA said the group has rules about the frequency of contact to clients, but no rules on how to characterize products. Then in April 2008, FINRA suggested investors read the offering documents on investments and said investors could file a complaint on the organization's Web site.
The SEC, while front and center in the Citi and UBS settlements and other ongoing auction-rate investigations, did not appear outwardly active in scrutinizing the auction-rate market prior to the onset of problems.
"The SEC is always the bridesmaid," Pan says. "They are never at the front of these enforcement actions."
Pan pointed out that the investment banks could have saved themselves from the problems they are now facing. Their objective was to make sure the auctions didn't fail, but they missed the big picture. The big risk they identified was the failure of the auctions, which most assumed would never happen. The unthinkable began happening in September 2007.
Silbert's company, Restricted Stock Partners, is taking advantage of the market dislocation and giving unhappy investors a place to unload their severely devalued auction-rate securities.
auction-rate securities are basically trading at par, but the student loan
auction-rate securities and the ones based on
collateralized debt obligations are pennies on the dollar," said Silbert. "That's where most of the damage was done."
Meanwhile, Citi, UBS and Merrill have moved to make amends with retail investors. New York Attorney General Andrew Cuomo on Monday
, including Morgan Stanley, to follow suit. Institutional investors have less recourse.
But it seems regulators could have avoided at least some of this pain, had they reacted to Pricewaterhouse back in 2005.
"If they had done more, we wouldn't be in this mess," Pan says.